Definition of Perfectly Competitive Market

It is a type of market in which there are large number of sellers selling homogenous product and large number of buyers and the price of the product is determined by the industry.

Characteristics of a Perfectly Competitive Market

Large number of sellers: due to which no individual seller can influence the market price because if any seller decreases its product price, then all the buyers will go to him and if any seller increases its product price, then no buyer would buy from him. Also, any increase/decrease in the supply of the firm would hardly affect market supply because the seller is very small component of the market. Hence, the firm is the price taker.

Large numbers of buyers:due to which no individual buyer can influence the market price or the market demand because the buyer too is a very small component of the industry. Hence, the buyer is also the price taker.

Homogenous product: the product sold by each seller is homogenous in all features and so, the buyers are indifferent between buying from any seller.

Free entry and exit: the firms in the industry are free to enter and exit in the sense that there is no technical or legal barrier which prevents the firm from entry or exit.

Perfect knowledge:this means that the buyers and sellers are fully aware of the market conditions.

No extra transport cost: this means that the buyer can buy from any seller when the price is same because there is no extra transport cost involved in buying from any other seller.

Perfect mobility:the factors of production are perfectly mobile and will move to that firm which pays the highest remuneration.

Independent decision making: the decisions on output and price are taken by the firms independently, (unlike the markets like oligopoly, where the firms take output and pricing decision based on other firms’ pricing and output decisions).

Example of Perfect Competition

In real world, markets like perfect competition hardly exist, but an approximate example is the agricultural market where the farmers sell identical products to market consisting of large number of buyers

Firm’s Demand Curve Under Perfect Competition

Firm’s demand curve is a curve which shows the quantities demanded (by the buyers) of the firm’s product at different prices. Demand curve of a perfectly competitive firm is a horizontal straight line parallel to x axis (as shown in the figure above). The demand curve is horizontal straight line because it is perfectly elastic which means that the firm can sell any quantity at the given price. This is because the firm forms a very small component of the industry. So, any amount of quantity the firm may sell, it would not affect the market supply much and thus would not affect the price.

Market Demand Curve Under Perfect Competition

The market demand curve is the curve which shows the relationship between price and quantities demanded (by the buyers) of the product of all the firms in the industry taken collectively. Under perfect competition, it is downward sloping straight line because unlike a particular firm, the industry cannot sell any quantity at the given price and it will be able to sell larger quantity only when it lowers its priceNote: a firm is a particular component of the industry while an industry is a collection of the firms.

Determination of Equilibrium Price Under Perfect Competition

Equilibrium price is the price at which the market demand is equal to the market supply and there is no excess or shortage of demand/supply. The quantity at which the market supply matches the market demand is called the equilibrium quantity.

Note: equilibrium price is determined by the interaction of market demand curve with the market supply curve and not the individual firm’s demand/supply curve.

In the figure shown above, quantity supplied/demanded is displayed on the x axis. The price is displayed on the y axis. S is the market supply curve. D is the market demand curve. These curves intersect at E which is the equilibrium point. The equilibrium quantity is 100 and the equilibrium price is 2.5. At this price, the quantity demanded is equal to the quantity supplied.

Price taker and price maker.

In perfect competition, the industry is the price maker where the price is determined by the interaction of market demand and market supply curve (as shown above), while the firm is the price taker. At the price determined by the industry, the firm can sell any output level.

Relationship between Price and MR in the Perfect Competition

In perfect competition, price= AR= MR because in perfect competition, price is constant and hence AR is also constant and, in any series, the average value can remain constant only when the marginal values are constant.

For example: let the price of the output of a perfectly competitive firm be $10. Then, as per following table, price= AR= MR in perfect competition.